Why Do Financial Crises Happen? 'Moods and Markets' Reviewed

Based on the author's Horizon Preference theory, this book will give investors a feel for what part of the market cycle we're in, and how to profit from it.

Editor's note: The following review looks at Moods and Markets: A New Way to Invest in Good Times and in Bad, by longtime contributor and Minyanville Media Inc. board member Peter Atwater. The book, which was prompted by this November 2009 Minyanville interview with socionomics pioneer and Elliott Wave International president Robert Prechter, and recently published by FT Press, outlines Atwater's "Horizon Preference" theory. It suggests that rather than focusing solely on traditional economic indicators -- CPI, GDP, the Dow Jones Index (^DJI),the VIX (^VIX), or S&P 500 (SPY) -- investors who want to know which way the market is going should consider readily available real-time indicators of social mood, including news headlines, protest movements, and even popular themes in culture. Get your copy here.

This book is about the questions every investor wants answers to:

Why do I tend to get into and out of the market at the wrong times?

Why are professionals prone to the exact same problems?

Why do financial crises happen?

Is there a way to approximately measure where we are in the overall market cycle?

The author has a theory that he calls "Horizon Preference." Think of it this way: When the market is near bottom, market players have very short time horizons for investment. They hide in cash. More than that, they choose very generic investments; they stay close to home and keep things simple. Fear drives them back to what they know always works in the very short run, which means any opportunity for gain is lost.

At such a time, only the most risk tolerant and experienced remain holding risky assets. Valuations are low. The party is over, the young have left, and the old guys are cleaning up the room. If you look in a financial newspaper, or out on the Web, the headlines you read are pervasively negative. But at a true bottom, you'll see that things have stopped getting worse.

Then optimism begins. It's fitful at first. It is two steps forward and one step back, before it becomes three steps forward and one step back, before it becomes an unrelentingly good trend. But as this happens, moods and headlines, move from disbelief, to doubt, to wonder, to optimism, and to greed. As this happens, market players expand their horizons. They are willing to take on new risks, with new instruments, and in new places. They are willing to pay remarkably higher prices for risky assets. This happens with individual investors, professional investors, bankers who make loans, regulators, accountants who have to make the numbers for management, etc.

At the top, everything is wondrous. Nothing can go wrong. At the top, the attitude is: "We are going to make a lot of money." It's as if money were free and anyone in the market at the moment can make it. Everyone can be rich -- just invest in the market. All of the neophytes are playing in the market. The experienced professionals who have seen a few market cycles have begun to edge out of the market, if not raise significant cash. Risk control is derided as a way of losing money. Real heavy hitters don't need risk control.

All of the discretionary cash is applied to the markets. Various forms of leverage are applied to personal investments, real estate, and business investments. Because everyone knows things are going to go well, they figure they may as well play it to the hilt.

But at the top, things stop getting better. Then pessimism begins. It's fitful at first. It is two steps back and one step forward, before it becomes three steps back and one step forward, before it becomes an unrelentingly bad trend. Sadly, during the phase of pessimism, things move down about twice as fast as they went up. It's frightening, and it should be. Bear markets tend to persist until the bad ideas and investments of the up cycle are liquidated, unless the government steps in to arrest the fall.

The planning horizons of businessmen and investors shrink, as do valuations, until we hit the bottom, and the cycle starts again.

What I have described to you is the basic framework of the book. The author then applies that framework to the housing bubble, the possible higher education bubble, changes to accounting frameworks as rising preferences change, and where we are today in the markets. He gives a tour of the various phenomena inside corporations that take place at different points in the cycle. Optimism breeds complexity, lack of risk management, concept stocks, big projects, and a lot of credit. Pessimism breeds simplicity, renewed risk management, and bankruptcies.

This book will give you a feel for what part of the market cycle we're in, and how you can profit from it. It is not math intensive; the book has no equations. There are a lot of graphs, but they are simple to understand.

Quibbles

In one sense, this book is about the credit cycle, and how it affects all risky assets. But it is couched in the language of how moods change in market participants, which then drives the market. My view of the matter is slightly different. I see market players making estimates of their future well-being, and as that estimate changes, their moods change, and the prices of risky assets changes. I don't think this is a big difference from what the author is saying, so I heartily endorse this book.

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